Academic journal article The Cato Journal

The Case for Market-Based Regulation

Academic journal article The Cato Journal

The Case for Market-Based Regulation

Article excerpt

In this article, we reconsider the rationale for government regulation of markets. We begin by identifying markets as governed not only by prices but also by evolved institutions, rules, and standards. We then analyze how this complex order regulates human behavior, discuss the case for adding a layer of government regulation to the market's own regulatory system, and present a number of case studies to clarify the issues.

Our focus is not on the familiar public choice criticism of government regulation--namely, that regulation is more about the pursuit of economic rents than protecting the so-called public interest. While that criticism is correct and we make reference to it where appropriate, the thrust of our argument is that market self-regulation is often superior to government regulation, which frequently is a solution in search of a problem.

Two Types of Regulation: Market vs. Government

In a system of private property rights and competitive markets, prices regulate the behavior of consumers and producers so as to allocate resources to their highest-valued use. The price system works within a framework of institutions. A market economy evolves institutions, rules, and standards that further regulate the behavior of economic agents.

The reality of how markets operate contrasts sharply with textbook neoclassical theory in which anonymous buyers and sellers meet for an instant to exchange homogeneous goods at preordained equilibrium prices. The idea that prices alone allocate resources in a market economy is at best a limiting case and at worst a straw man.

Institutions and prices evolve through a similar process to jointly coordinate behavior. Part of that process involves the development of market-based regulation. There is no magic to the evolutionary process, any more than there is mystery in the rise of oil prices to reflect increased scarcity of that commodity.

The textbook justification for government intervention is the correction of an apparent market failure. It is now widely recognized that market failure, such as pollution, results from incompletely specified property rights. In the case of air pollution, for example, individuals do not have an enforceable and tradable right in air quality. (1) Merely postulating weak or absent property rights, however, begs the question. That procedure falls under Hayek's dictum that "before we can explain why people commit mistakes, we must first explain why they should ever be right" (Hayek [1937] 1948: 34). In O'Driscoll and Hoskins (2003), we analyzed the process by which property rights emerge. We briefly reprise that argument in the next section.

It is widely recognized that regulatory intervention attenuates private property rights. Governments can theoretically define property rights where they do not exist, but public choice theory would predict that the process would end up in rent seeking rather than law making. (2) In any case, rather then creating property rights in the face of apparent externalities, governments typically turn to regulating economic activity. That is the topic of this article.

Government regulation alters the allocation of resources and, indeed, is designed to accomplish just that reallocation. Along with attenuating property rights, government regulation can also undermine the complex system of market-based institutions, rules, and standards that enhance and strengthen property rights. That system, or institutional framework, is as an integral part of a market economy as is the price mechanism.

All economies have elements of both self-regulation and government regulation. Government regulation reinforces, supplants, or undermines market-based regulation. Accordingly, government intervention is efficacious, redundant, or counterproductive. We address classic textbook cases of public goods and externalities that suggest the case for "good" government regulation. …

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